Fears of collateral drought questioned

Have fears of global shortage of high-grade collateral been exaggerated?

As the world braces for several more years of painful deleveraging from the pre-2007 credit excesses, one big fear has been that a shrinking pool of top-rated or AAA assets — due varioulsy to sovereign credit rating downgrades, deteriorating mortgage quality, Basel III banking regulations, central bank reserve accumulation and central clearing of OTC derivatives — has exaggerated the ongoing credit crunch. Along with interbank mistrust, the resulting shortage of high-quality collateral available to be pledged and re-pledged between banks and asset managers, it has been argued, meant the overall amount of credit being generating in the system has been shrinking, pushing up the cost and lowering the availability of borrowing in the real economy. Quantitative easing and bond buying by the world’s major central banks, some economists warned, was only exaggerating that shortage by removing the highest quality collateral from the banking system.

But economists at JPMorgan cast doubt on this. The bank claims that the universe of AAA/AA bonds is actually growing by around $1trillion per year. While central bank reserve managers absorb the lion’s share of this in banking hard currency reserves, JPM reckon they still take less than half of the total created and, even then, some of that top-rated debt does re-enter the system as some central bank reserve managers engage in securities lending.

Citing a recent speech by ECB Executive Board member Benoit Coere dismissing ideas of a collateral shortage in the euro zone, JPM said ECB action in primary covered bond markets and in accepting lower-rated and foreign currency collateral had helped. It added that the average amount of eligible collateral available for Eurosystem liquidity operations was 14.3 trillion euros in the second quarter of 2012 — with 2.5 trillion euros of that put forward as collateral by euro zone banks to be used in the ECB’s repo operations of 1.3 trillion. Critically, the majority of that 2.5 trillion posted at the ECB was either illiquid collateral such as bank loans or collateral associated with peripheral issuers and thus unlikely eligible for use in private repo markets anyway, they added. This process of absorbing low quality collateral in order to free up higher-quality assets for private use has been an approach of both the ECB and Bank of England.

More generally, JPM argues that strict AAA requirements across the financial system are a thing of the past. The likes of tri-party repos in Europe now accepting AA paper, for example, and there are few bond funds left with specific AAA mandates. Similar restrictrions have disappeared for most insurance and pension funds. While central banks have bought some $3.5 trillion of bonds since 2008, they have created about $5 trillion of reserves via QE and long-term repos and that net $1.5 trillion of cash is collateral of the highest quality. Neither did detailed analysis of Basel III liquidity coverage needs or OTC derivatives central clearing needs throw up onerous collateral requirements, they said.

Are these (collateral shortage) worries justified? Not in our opinion. The universe of AAA/AA bonds is actually growing in absolute terms. It has grown by $9tr (in the Barcap Multiverse index) since the end of 2008. We expect around $1tr of extra AAA/AA bond supply a year over the coming years due to elevated and persistent government deficits among major developed countries.